The Big Question

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September 2007

Question: How can advisers help clients to minimise the impact of inflation on their retirement savings?

Each month, we ask our industry to answer one big question!

Nick Bladen is head of pensions marketing at Skandia

A key part of the adviser's role is not just assessing the client's individual attitude to risk, but helping them to understand the very real risks posed by inflation. By balancing the two, the adviser and client can set realistic investment objectives.

Once a retirement portfolio has been constructed, it should be reviewed regularly. At each review, inflation also needs to be considered so that it is monitored and understood throughout the entire life cycle of the pension. The decisions made at retirement are another key milestone where it must be considered in depth. Whether the choice is made to go into income drawdown or purchase an annuity, the client needs to appreciate the effects that inflation can have.

Simon Brett is head of investments at Parmenion

Recently inflation has been low with the Bank of England now mandated to keep it at a level of 2.5%. This is in stark contrast to the 1970s when the rate at one point reached 25%.

Over the long term equities as an asset class have provided the best real return versus gilts and cash.

However one should be aware that the returns from equities are more volatile than gilts and cash, the classic "risk/return trade off". When investing for the long term an investor will be able to ride out the volatility. When nearing retirement the investor can switch to less risky gilts in order to reduce the risk of the retirement fund.

James Davies is head of investment research at Chartwell

It is important, first of all, that advisers actually make clients aware that over time inflation can have a pronounced effect on savings.

Secondly the adoption of an investment strategy that targets an absolute return is important; and doesn't simply aim to outperform an index. A cash plus strategy works well and perhaps provides a more tangible objective for a client; but one that targets returns above inflation is obviously better for these purposes.

Finally, attention to asset allocation is perhaps most important of all. Equities and especially commodities are the most likely to beat inflation over the longer term; but investment into these assets can be a hair-raising experience - particularly for retirement planning. Combining the equity and commodity investments with less risky and negatively correlated asset classes, such as bonds, property, cash and alternatives (to create a multi-asset strategy) will maximise the potential for the strategy to perform over the long term.

Bernard Footitt is technical support manager - pensions at Canada Life

The vehicles for accumulating savings for retirement are primarily pension schemes backed up by saving through other tax-privileged schemes, e.g. ISAs. Some people prefer to eschew these tax-privileged options and invest in property that relies on increases in capital value over time and reliable rental income streams.

If the impact of inflation was the only hazard to neutralise at retirement, pension schemes should purchase an income ideally on a fixed escalation basis or capable of retaining potential for growth to outstrip inflation alongside the provision of an income.

Unsecured pension (USP) can do this, however the risk associated with income drawdown is high. There are retirement income arrangements that reduce the risks associated with USP by offering income security, typically for five years at a time, while boxing away investment control with inflation-busting growth potential through active management of the invested capital.

Andrew Gadd is head of research at The Lighthouse Group

The answer to this question depends on the precise circumstances that we are considering. For the sake of simplicity I am going to assume the client is aged 65 and has a defined contribution scheme from which he/she now wants to start to draw an income.

After deciding whether to take the tax free lump sum currently an individual basically has four choices: (a) annuitise, (b) unsecured pension, (c) use one of the new "hybrid" products from providers such as Living Time or (d) any combination of the previous three.

With annuities it is possible to index link these to protect against inflation, but only at a cost. With plans such as Living Time an investor has the certainty of a set return in monetary terms without locking into a "level" annuity and finally with drawdown, depending on the risk profile and other assets of the client, an appropriate asset allocation can be implemented to hedge against inflation.

Aston Goodey is director of business development for annuities at Prudential

Those looking to take an income in retirement can protect against inflation by buying a conventional annuity linked to the RPI index. This is very straightforward and does what it says on the tin; however it does come at a cost. Typically the starting income will be about a third less than a conventional annuity and could take about 11, 12 years before the income reaches the same level as conventional annuity. Needless to say these are not popular options with consumers as they are often looking to maximise starting income. Advisers are now looking at other alternatives such as utilising real assets to create a natural hedge against inflation i.e. unit linked and with-profit annuities.

Peter Hicks is head of IFA channel at Fidelity International

In the saving years, many investors are unnecessarily cautious investing in low-risk assets, particularly cash, which might not provide enough growth to build a big enough retirement pot. There is also a tendency to save too little too late. The message to these people is that the short-term volatility of growth assets is usually eased by long-term gains so consider increasing exposure to these assets.

When someone retires and starts to withdraw money from their pot in the form of income then the risk is that inflation will reduce their purchasing power. In order to counter this effect they will need their income to increase over time - not just remain flat.

People need to think about what will provide both an increasing income over time and grow their pot of money. This is where asset allocation is really important as while the short term volatility of equity investment becomes more salient as they are no longer topping up their pot (they are in fact doing the opposite), for most people an element of equity investment - perhaps around 30% - should provide the long term growth in both income and assets without adding too much risk.

Mike Kalen is CEO at The Hartford

History has shown us that investing in equities is a proven way to keep pace with inflation. For many, exposing our pension pots to the turbulence of financial markets, through income drawdown schemes, is an unacceptable risk.

The past 12 months have seen the highest level of pensions innovation for a generation. Through the introduction of guaranteed drawdown, or 'third way' products as they have become known, solutions are available to provide retirees with the certainty they need AND the potential to combat the affects of inflation.

Kim Lerche-Thomsen is founder and chief executive of Living Time

Retirees in the future will need to understand the possibilities of linking their two main assets - their pension pots and their homes. Rising property prices and regulation has brought equity release firmly into the mainstream. Property prices tend to rise faster than general inflation, over the last 10 years at more than double the pace.

Many of those reaching retirement, particularly those with modest pension pots, could in early retirement generate a higher income by going into income drawdown, or using a low-cost fixed-term annuity. Fixed term annuities offer similar security to an annuity but which has the flexibility to pay out an income of up to 20% a year more than the equivalent annuity. The pot will be drawn down more quickly, but this shortfall could be made up later in retirement through equity release when more value can be released from the property due to the client's greater age and the likely rise in property prices over time

Jon Maguire is CEO at cru Investment Management

To successfully protect their clients from the capital eroding effects of inflation over the long term advisers need to ensure that a client's investments continually outstrip inflation year-on-year. Where possible this is best done by investing in the private market space. In private markets it is possible to generate a more consistent return without the value distortions and inevitable volatility that occur in the public bond and stock markets. By straight lining growth of 10-14% per annum it is possible to enjoy an income of 7% per annum and still protect the capital from any inflation risk.

Mike Morrison is pensions strategy manager at Winterthur

It is important to remember that retirement decisions are long term decisions, particularly as more people are living longer. Even a relatively low inflation rate of 3% per annum will halve the purchasing power of a level income in about 23 years. Retirement could well exceed 23 years!

Any advice given must consider these issues and plan forward. Does unsecured income allow more opportunity for investment growth than annuity purchase?

If an annuity is to be purchased, then should it escalate? Is the client prepared to accept a lower income today in return for built in increases? Where is the break even point between the level and the escalating annuity?

Further development of retirement planning products can only assist!

Jarrod Parker is technical consultant at Alexander Forbes Financial Services

For the majority of people, whose funds at retirement are too small to risk an investment environment, conventional annuity purchase is the most likely option that will be selected. This presents a dilemma as to whether or not to build in inflation protection. For conventional annuities, an inflation-linked annuity provides a much lower initial income than a non inflation-linked annuity. Current best estimates are that it would take up to 18 years for an inflation linked annuity to catch up with a level annuity if inflation runs at 5% pa.

For those clients intending to keep their pension funds invested during retirement (for example via unsecured income) it is vitally important that advisers closely monitor risk and asset allocation strategies, both for the pre and post retirement periods. Achieving and maintaining the correct balance of assets to provide both income and future fund growth is crucial in helping minimise the inflation risk.

David Philips is corporate pensions and benefits director at BDO Stoy Hayward Investment Management

For the client who purchases an annuity the increased aspect of longevity must be an increasing consideration at the point of advice to show the benefits of adding indexation to the plan. A simple matrix showing the point at which a level annuity is improved on an indexed basis must be a factor for the client to consider. Too often the appeal of the higher starting pension overrides sense of what the future income requirements may be.

For the client in control of the pension assets in retirement, for instance in unsecured pension, the options for controlling inflation are available through appropriate asset allocation. Too many advisers still review their clients against a subjective view of 'low' 'medium' and 'high risk' investment strategies and do not have regard to 'real' returns, for instance the returns above those available against cash returns.

Mike Phillips is head of distribution at MetLife Europe

Given that most pensioners are on fixed incomes and that longevity is increasing it is clear that new strategies, which go further than the traditional routes of conventional annuities and drawdown, are required.

Advisers need to understand the full range of new products available on the market and how they enable clients to maximise income while minimising risk.

Clients need products which offer sufficient flexibility to allow them to stay invested while not being at the mercy of the markets. Taking risks with retirement savings is not a strategy to beat inflation.

Mark Polson is head of corporate business at Scottish Life

Inflation is without doubt one of the greatest risks that pension savers face. There are two main ways that they can help themselves minimise its effects. The first is simply to ensure they factor inflation in when deciding how much to save. Just as importantly, the right - or wrong - investment choice can make the difference between success and failure. It's possible to build portfolios that control risk on a number of levels - including inflation risk - but investors need to be clear what their objectives are. It's like playing a par 3 golf hole downwind - you can't just hit and hope with any club.

Most pension savers, especially those using default funds, are engaged in the investment equivalent of hacking around in the rough and hoping for the best. Having the right portfolio at outset isn't enough - it needs to be regularly checked to ensure it stays relevant over time.

David Seaton is director of consultancy at Rowanmoor Pensions

It is vital that clients properly understand how inflation can devalue their savings and income over their true life expectancy and properly plan to mitigate that erosion. Unfortunately, inflation proofed products are either uneconomic or simply not available. When I tried to buy a purchase life annuity for my 75 year old mother-in-law I found no one offered one with RPI increases. A 60 year old client was offered either a 3% increasing compulsory purchase annuity or a level one. Comparison showed that he would have to reach 84 before the increasing annuity paid the same income as the level annuity and he would be 103 before he had received the same total income from the two options.

Clients must be helped to understand the true effect of inflation and plan savings to ensure sufficient income for the rest of their lives.

Adrian Shandley is managing director at Premier Wealth Management

In the investment world there are very few golden rules upon which we can rely. However, one of the most constant truths is that dividend/yield income is the only true income. If we are to assist our clients in protecting their savings from the effect of inflation, then an income focus is critical.

There are lots of products in the marketplace that all claim to inflation link capital or give a guaranteed rate of return. Yet, there is no substitute for dividend/yield.

Unit linked investment is one of the few areas that can offer a differentiation between income and capital growth. So, to clearly identify the fact that the capital is rising in line with inflation, or perhaps by more than inflation, we have to be able to clearly identify the capital and the income.

While portfolios can be adjusted according to client risk profile, it does not matter whether they invest in bonds, equities or property trusts, this differentiation has to be present.

The best way to help our clients to protect their savings from inflation is to get them to recognise this fact.

Russell Vidler is a consultant at IFG Financial Services

While inflation remains historically low, it is easy to see what constitutes the most cost-effective method of inflation-proofing available.

Ever since their introduction in 1988, the Government has been paying hefty incentives into personal pensions, which in many cases, has amounted to full tax relief at 40%. Now that the outrageously expensive prototypes have given way to new style personal pensions costing no more than 1% per annum to run, there has never been a better time to invest.

At outset, the costs of a contract and the tax relief available to investors in pensions are known quantities which should sell the concept better than any glossy literature or colourful fund performance graphs ever could.